NEW YORK — The recent trends affecting Wall Street appear somewhat counterintuitive.
The bond market has experienced notable fluctuations lately, pushing the yield on the 10-year Treasury above 4.80%, marking its highest point since 2023. These shifts have generated unease within the U.S. stock market, causing major indexes to pull back from their peak performances.
Despite the Federal Reserve’s decision to lower interest rates three times starting in September, the bond market’s actions may seem puzzling. This scenario highlights a critical aspect of market behavior: investors often prioritize future projections over current conditions. The bond market is expressing concern about potential inflation increases down the line, alongside an economy that may not necessarily benefit from reduced interest rates. This situation is having a tangible impact on stock valuations.
Since September, the Fed has lowered its primary interest rate by a total of one percentage point. The aim of this strategy is to provide some leeway for the economy after previously raising the federal funds rate to a 20-year high in an attempt to cool off the economy and combat inflation.
However, the Fed’s authority has limitations regarding the interest rates that are currently influencing the stock market, particularly the yield on the 10-year Treasury. The federal funds rate is a short-term interest rate that governs the borrowing costs for banks, meaning its effect is mainly on overnight borrowing.
Conversely, the 10-year Treasury yield is determined by investors. While these investors certainly take the Fed’s decisions into account when deciding the yield they require for U.S. Treasuries, their assessments also heavily consider economic growth projections and inflation trends.
Interestingly, the 10-year Treasury yield started its upward trend in September, rising from 3.65% just as the federal funds rate began to decrease for the first time since 2020. This increase occurred despite the fact that the Fed was lowering overnight interest rates, as expectations for economic growth and inflation were concurrently rising. This positive outlook has been supported by a series of reports revealing that the U.S. economy remains more robust than many had anticipated, though inflation has remained resilient. Nonetheless, recent data has showed some signs of improvement, resulting in Treasury yields slightly retracting from their significant gains.
A similar, though inverse, situation unfolded in the late months of 2018. At that time, the Fed was increasing the federal funds rate, and the 10-year Treasury yield was also on the rise for much of that period. However, the 10-year yield began to decline before 2018 closed, continuing to drop even after the Fed raised rates in December of that year, as investors anticipated that the rate hikes would cease before overly burdening the economy.
Then-President-elect Donald Trump also plays a crucial role in the current dynamics. His inclination to impose tariffs on imports could drive inflation upwards, along with his preferences for tax cuts possibly exacerbating the federal debt. This situation may lead investors to demand higher interest rates to compensate for the added risks.
The Federal Reserve has indicated recently that it might only reduce interest rates twice in 2025, down from previous forecasts that suggested four rate cuts. This has led traders on Wall Street to speculate whether any short-term interest rate cuts will take place at all in 2025.
Even a recent positive report regarding an underlying inflation measure was insufficient to provide the market with a sense of security. “We believe it will likely take several months of declining inflation for both the Fed and the market to start considering another rate cut,” noted a market strategist from Wells Fargo Investment Institute.
